Eighth Wonder of the World: Compounding!

Updated: Oct 19, 2020

-Saving money is of course the first necessity in building your nest egg. However, if that money just sits in cash then it is actually losing value year after year due to the inevitable forces of inflation. To really accumulate wealth you need to leverage the forces of compounding. This means investing your money in a manner where you earn a return on that money. Then, the next year you are able to earn a return on your original investment plus a return on your earnings from the previous year, and so on. As Albert Einstein once said “Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.”

Unfortunately, the average investor has a hard time doing this. Not because of the lack of good investments available out there but from their lack of experience with the principles of investing. This being said please make sure you remember that before you begin investing always make sure that you have a little savings set aside, known as you emergency fund. This is crucial so that no if, but when the unexpected happens you have access to cash without being forced to sell an investment to cover the cost. Examples of compounding.

-Finally making some good money! Now what? –

You are still young and are finally starting to see some extra discretionary cash coming in. You want to be responsible so start saving in the future and invest the money in the most aggressive investments you can find, right? I mean you are young and have a long time horizon in front of you so that is the best thing for you to do, isn’t it. Well, yes and no. First, you need to take a look at your current and future liabilities. If you have high interest debt like credit card debt; that should be the first thing you work towards paying off. Next, you always have to begin thinking a few years down the road. Even though you may not be thinking about it now, you could have some large expenses looming right around the corner… an engagement ring, a down payment for a new home, ect. And the last thing you want is for those investments to crash right before you need the money. So, you should definitely forget about investing until you have built yourself up a comfortable emergency fund. As the name implies, it should be large enough to cover any unexpected emergencies and any expected large expenses that may arise in the next six months.

Where you should begin investing immediately is your employer’s 401k plan, if they have one. More specifically, find out if they offer some sort of match or profit sharing arrangement. If so, max out the match, this is free money from the employer and must be taken advantage of. Now, in that retirement plan if you are certain that you will never have to take a hardship withdrawal or loan from it (which I would strongly recommend against) then having an aggressive investment strategy may make sense. However, as always speak with a good Financial Advisor to assist with a plan and investment strategy.

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